The Grossman–Miller Market Making Model with

and without Trading Costs

April 11, 2017

Contents
1 Market Definitions 1

2 Optimum Quantities and Liquidity Premium 2

3 Trading Costs 9

4 Acknowledgments 16

Bibliography 17
 Abstract

This paper extends Grossman & Miller’s market liquidity model [GM],
which was presented in the Market Microstructure lecture notes [C]. Market
liquidity is modelled by the demand and supply of immediacy. Market makers,
as hedgers, provide this liquidity by accepting trades of other agents in the
market, taking the market risk of price change during the time period between
the first trade and the hedging trade with the arrival of the final buyer or seller.
The first section defines the market assumptions and in the second section the
equilibrium quantities of asset holdings and the liquidity premium are deter-
mined. In the final section the liquidity theory is generalised by consideration
of trading costs.

1 Market Definitions
In this section we consider a formal model of market liquidity presented by Grossman
& Miller in [GM]. Assume the market consists of two tradable assets, namely a risk–
free asset called cash B with zero rate of return and a risky asset S (share) with
price St at time t. The market players (referred to as agents) are liquidity traders
(outside customers) LT and market makers (liquidity providers) M M , who can only
trade at the three dates t ∈ {1, 2, 3} ⊂ {0, 1, 2, 3}. Date t = 0 is only introduced for
the initial balances of the agents and date t = 3 is introduced for valuation purposes
of the securities. The asset price St ≥ 0 at each point in time t is to be considered
nonnegative and let Btj respectively Wtj denote the cash holdings respectively wealth
of agent j at time t. The quantity of the asset S an agent j holds at a time t is denoted
as qtj . Moreover, we assume that the initial aggregate holdings of the asset by all the
agents are equal to zero, that is j q0j = 0 and market makers do not have initial
P

asset holdings. If, for example, the market players are a market maker M M and two
liquidity traders LT1 and LT2 , then the quantity equations are q0M M = q0LT1 +q0LT2 = 0.
If LT1 has an initial endowment of q0LT1 = n 6= 0, which will be sold to M M at the date
t = 1, then LT2 has an initial endowment of q0LT2 = −n, that will be compensated by
a purchase of n units in a trade with M M at t = 2. A market maker provides liquidity
by accepting one side of a trade offered by a liquidity trader, who wants to sell or buy
the asset at a certain time t = 1. Since the market making agent will hold the (long
or short) position in the asset for an uncertain period of time, that is to say until
another liquidity trader comes to the market to demand a complementary position at
time t = 2, he is exposed to the market risk of asset price changes during that time

1
interval. The market maker has no desire to speculate on price changes and holding
any inventory, that is why he only buys or sells in anticipation of a subsequent sale or
purchase. His business model is to obtain a liquidity premium from the counterparty
liquidity traders to compensate him for carrying the price risk until he transfers it
later to another liquidity trader. The positive difference between the bid and ask price
implied by the liquidity premium respectively discount of the asset is called spread.
Starting with a constant price S1 = µ ≥ 0 at t = 1, the asset price at the time t = 2
changes to S2 = (S1 + 2 )1{S1 +2 >0} with a shock 2 , that is normally distributed with
zero mean and variance σ 2 > 0. The indicator function 1 ensures the nonnegative
asset price. At t = 3 the asset prices changes to S3 = (S2 + 3 )1{S2 +3 >0} , that can
be also expressed as S3 = (S1 + 2 )1{S1 +2 >0}∩{S1 +2 +3 >0} + 3 1{(S1 +2 )1{S1 +2 >0} +3 >0}
with 2 , 3 ∼ N (0, σ 2 ) independent and identically distributed. For simplicity, the
indicator factors are dropped by writing

S3 = S2 + 3 = S1 + 2 + 3 = µ + 2 + 3 , (1)

since they are not needed for the optimisation problems in the next section delivering
a market player’s optimum quantity of asset holdings and liquidity premium. Lastly,
for the next section it is assumed that there are no trading costs (transaction costs)
other than the liquidity premium.

2 Optimum Quantities and Liquidity Premium

The problem of determining the agents’ optimum quantities and the liquidity premium
as a measure of market liquidity will be solved backwards in time. This is done by
formulating two optimisation problems given the market information at t = 2 and
subsequently t = 1. A common used negative exponential process is applied to model
all the market players’ utility preferences.

Theorem 2.1. Under the assumption, that all traders in the market are risk–averse
by giving an utility function U (Wtj ) = − exp(−γWtj ) with a risk aversion parameter
γ > 0, an agent j chooses q2j at t = 2 to maximise his expected utility
j 
  
max
j
E U (W 3 ) 2 , (2)
q2 ≥0

given the realisation of 2 with subject to

W3j = B2j + q2j S3 , (3)

W2j = B2j + q2j S2 = B1j + q1j S2 . (4)

2
Then the expected utility is given by

E U (W3j )  2 = − exp −γ W2j + q2j (E [S3 | 2 ] − S2 ) + 21 (γq2j σ)2

  


(5)

with the optimum quantity

E [S3 | 2 ] − S2
q2j,∗ = (6)
γσ 2
as the solution to the maximum problem (2). This implies q2j,∗ = 0.

Proof. If the cash value B2j is eliminated from (3) and (4), we can express the terminal
wealth by
(3) (4)
W3j === B2j + q2j S3 === W2 − q2j S2 + q2j S3 = W2 + q2j (S3 − S2 ). (7)

Using the formula E[exp(X)] = exp E[X] + 21 Var[X] the expected utility function

at t = 2 is

E U (W3j )  2 = E − exp −γW3j  2 = − exp E −γW3j  3 + 21 Var −γW3j  2

   
       

(7)
=== − exp −γE W2 + q2j (S3 − S2 )  2 + 21 γ 2 Var W2 + q2j (S3 − S2 )  2
     

= − exp −γ W2j + q2j (E [S3 | 2 ] − S2 ) + 21 (γq2j )2 Var [S2 + 3 | 2 ]

= − exp −γ W2j + q2j (E [S3 | 2 ] − S2 ) + 21 (γq2j σ)2 ,

where Var [S3 | 2 ] = Var[S2 + 3 ] = Var[3 ] = σ 2 under (1) and the independence of
2 and 3 . After (5) has been shown, the maximum problem (2) can be solved by
differentiating the expected utility
∂  j 
  (5)  j 
  j 2


E U (W3 ) 2 === E U (W3 ) 2 −γ (E [S3 | 2 ] − S2 ) + q 2 (γσ) .
∂q2j

and setting it equal to zero. Since the utility function U (Wtj ) = − exp(−γWtj ) and
hence its conditional expectation is always nonzero, the optimum quantity q2j,∗ solves
the equation
−γ (E [S3 | 2 ] − S2 ) + q2j,∗ (γσ)2 = 0. (8)
E[S3 | 2 ]−S2
The solution to (8) is q2j,∗ = γσ 2
from (6). In view of (1), the last implication
is simple. It is

E [S3 | 2 ] − S2 (1) E [S2 + 3 | 2 ] − S2 S2 − E [3 | 2 ] − S2

q2j,∗ = 2
=== 2
= = 0,
γσ γσ γσ 2

in accordance with E [3 | 2 ] = E[3 ] = 0.

3
 After Theorem 2.1 no market player at t = 2 wants to hold open positions in the
risky asset S until date t = 3. The reason is the conditional expected return of the
asset, which by construction (1), is zero. This follows of the decomposition of the
conditional random variable

S3 | 2 = S2 | 2 + 3 = µ + 2 | 2 + 3 ∼ N (S2 , σ 2 )
| {z } |{z}
deterministic random

into the deterministic term S2 | 2 = µ + 2 | 2 and the random term 3 ∼ N (0, σ 2 ).

Another approach to see E [S3 | 2 ] = S2 is to equate demand and supply (called
market clearing) for the asset
X X X
0= q0j = q1j = q2j (9)
j∈J j∈J j∈J

for all quantities qtj at the relevant dates, where J denotes the set of all market
players. The first equation is the assumption of equilibrium concerning the initial
endowments of the asset. Inserting the optimum quantities q2j,∗ into q2j at t = 2
| 2 ]−S2
provides |J| E[S3 γσ 2 = 0 and eventually E [S3 | 2 ] = S2 . Since the agents are risk–
averse, there is no reason to hold a risky asset S without any expected return between
the dates t = 2 and t = 3 but a variance of Var [S3 | 2 ] = σ 2 . The expected utility
given by the negative exponential function decreases when the standard deviation
σ as a parameter of risk increases. Thus, it is better to hold the risk–free cash B
without any return and risk.

Remark 2.2. The assertions of Theorem 2.1 are stated in [C, p. 5] without proofs.
In addition, the reference contains a mistake in the formula of the expected util-
ity function E U (W3j )  2 = − exp −γ W2j + q2j E [S3 | 2 ] + 21 (γq2j σ)2 , where the
  

subtraction of −S2 is missing compared to the correct formula (5).

In the original source [GM, p. 624] the approach of the model is slightly different
to the one we introduced. If the initial endowment of a trader is q0j , then the trader’s
excess demand is defined as q̃tj = qtj − q0j for t ∈ {1, 2}. However, the results of
Theorem 2.1 can be obtained easily for the equivalent problem of the reference by
writing q̃2j + q0j instead of q2j . Then the expected utility becomes

E U (W3j )  2 = − exp −γ W2j + (q̃2j + q0j ) (E [S3 | 2 ] − S2 ) + 21 (γ(q̃2j + q0j )σ)2 ,

  

which leads to the optimum excess demand

E [S3 | 2 ] − S2
q̃2j,∗ = 2
− q0j . (10)
γσ

4
With the notation of excess demand q̃tj the initial number of shares that an agent
holds is considered in the model. This implies different optimum excess demands q̃2j
for each agent j. It is sufficient to look again at the simple market with the three
agents M M , LT1 and LT2 , because the case with more agents as stated in [GM] can
be simplified by grouping them as trader types LT1 , LT2 or M M and aggregating the
holdings qtj . If the liquidity trader LT1 , who trade with the market maker M M at
t = 1 has an initial quantity q0LT1 = n of S, then the liquidity trader LT2 , who does
the opposite trade with M M at the time t = 2, has an initial quantity of q0LT2 = −n.
Note, that n can be either positive, negative or zero. The latter would result in no
trades at all and is therefore excluded for the whole work. A negative n would mean
that LT1 already has an open short position of n number of shares at t = 0 and
hedges this position at t = 1 by buying n number of shares from M M to compensate
the imbalance. With the assumption, that a market maker M M as a hedger do not
have initial asset imbalances q0M M = 0, from (10), the optimum excess demands of
the three parties are

E [S3 | 2 ] − S2 E [S3 | 2 ] − S2 E [S3 | 2 ] − S2

q̃2LT1 ,∗ = − n, q̃2LT2 ,∗ = + n, q̃2M M,∗ = .
γσ 2 γσ 2 γσ 2
Market clearing at t = 2 delivers
X E [S3 | 2 ] − S2 E [S3 | 2 ] − S2 E [S3 | 2 ] − S2
0= q̃2j,∗ = 2
−n+ 2
+n+
γσ γσ γσ 2
j∈{LT1 ,LT2 ,M M }

E[S3 | 2 ]−S2
and hence γσ 2
= 0 from which E [S3 | 2 ] = S2 follows. Therefore, the optimum
excess demands at t = 2 are q2LT1 ,∗ = −n, q2LT2 ,∗ = n, q2M M,∗ = 0. Consider now the
maximisation problem at t = 1 similar to the one in Theorem 2.1 for an agent j from
type LT1 or M M . Note that LT2 will not appear in the market until date t = 2.

Corollary 2.3. At the date t = 1 the portfolio decision of an agent j is expressed by

j
 
max
j
E U (W 2 ) | S 1 = µ , (11)
q1 ≥0

given the realisation S 1 = µ ≥ 0 of the efficient asset price S 1 with subject to

W2j = B1j + q1j S2 , (12)

W1j = B1j + q1j S1 = B0j + q0j S1 , (13)
S2 | S 1 = S 1 + 2 . (14)

5
Then the expected utility is given by

E U (W2j )  S 1 = µ = − exp −γ W1j + q1j E S2  S 1 = µ − S1 + 12 (γq1j σ)2

     

(15)
with the optimum quantity as the solution to the maximum problem (11),
  
j,∗ E S2  S 1 = µ − S1 µ − S1
q1 = = . (16)
γσ 2 γσ 2
Proof. Analogous to the proof of Theorem 2.1, by eliminating B1j from (12) and (13),
it is W2j = W1j + q1j (S2 − S1 ). Inserting this into E U (W2j )  S 1 = µ leads to the right
  

side of (15), when considering constraint (14) and that S1 can be moved out of the
conditional expectation due to the known value at t = 1. The realisation S 1 = µ of
the efficient price is announced between the dates t = 0 and t = 1. Differentiation of
(15) with respect to q1j and setting the derivative to zero, leads to the first equation of
the optimum quantity formula in (16). The second equation in (16) directly follows
from (14).

Remark 2.4. We gave a proof of Corollary 2.3, because the references [GM, p. 625]
and [C, pp. 6–7] skip most of the calculations and do not clearly explain why S1 is
not set to µ after moving it out of the conditional expectation E [S2 − S1 | S1 = µ].
However, it is important in (15) to distinguish between the efficient price S 1 and the
ask price S1 , because the formal difference S1 − S 1 is needed for the calculation of
the market maker’s premium. The ask price S1 is the asset price offered from the
market maker to a trader LT1 . If simply S1 = S 1 = µ is written, then the difference
of E [S2 | S1 = µ] − µ would be zero because of S2 = S1 + 2 = µ + 2 ∼ N (µ, σ 2 ) and
imply the trivial optimum quantity q1j,∗ = 0 in place of q1j,∗ = µ−S1
γσ 2
in (16).

According to Theorem 2.1 the expected value of S3 from the point of view of date
t = 2 is E[S3 | S2 ] = S2 , which is unknown at the time t = 1. The tower rule of
conditional expectation imply E [S3 | S1 ] = E [E [S3 | S2 ] | S1 ] = E[S2 | S1 ]. Hence, the
optimum quantity (16) also can be written as
  
j,∗ E S3  S 1 = µ − S1
q1 = . (17)
γσ 2
With the optimum quantity at t = 1 one can derive the market maker’s premium.

Theorem 2.5. Assume that there are m ∈ N market makers instead of one trading
with LT1 at t = 1. Then the optimal trade price is
n
S1 = µ − γσ 2 (18)
m+1

6
and the liquidity premium p a market maker receives from LT1 in equilibrium is
|n|
p := |µ − S1 | = γσ 2 , (19)
m+1
with q0LT1 = n initial number of shares of LT1 . In the case n > 0, LT1 sells n shares
at the ask price S1ask = µ − p and for n < 0, LT1 buys n shares at the bid price
S1bid = µ + p. Hence, the spread is 2p and the optimum quantity for each agent is
given by
n
q1j,∗ = . (20)
m+1
Proof. Let J := {LT1 , M M1 , . . . , M Mm } be the set of agents, where M M1 , . . . , M Mm
are m identical market makers. Equating demand and supply as in (9) provides
X j X j
0= q1 − q0 = m(q1M M − q0M M ) + (q1LT1 − q0LT1 ) (21)
j∈J j∈J

with M M ∈ J \ {LT1 }. Since LT1 has an initial endowment of q0LT1 = n and each
market maker initially has zero number of shares q0M M = 0, setting q1M M = q1LT1 = q1j,∗
as the optimum quantity from (16) into the equilibrium equation (21), leads to
  
j,∗ E S2  S 1 = µ − S1
0 = (m + 1)q1 − n = (m + 1) − n. (22)
γσ 2
After rearranging, it is
n   (14) 
γσ 2 = E S2  S 1 = µ − S1 ==== E S 1 + 2  S 1 = µ − S1 = µ + E[2 ] − S1
  
m+1
= µ − S1 ,

which is equivalent to the bid–ask price formula (18). The absolute value in (19) gets
clear, when considering that a risk–averse market maker receives an adequate positive
(18) |n|
liquidity premium p = |µ − S1 | ==== m+1
γσ 2 > 0 to compensate the market price risk
for holding the counterposition in S from t = 1 until t = 2 after trading with LT1 .
It can be a long or short position depending of the sign of n. If it is a long position
(n > 0), the M M buys n shares from LT1 at a discounted price S1bid = µ − p < µ. If
it is a short position (n < 0), the M M sell short −n shares to LT1 at a price premium
S1ask = µ + p > µ. Consequently, the spread s as the difference between the bid and
2|n|
ask price is s := S1bid − S1ask = µ + p − (µ − p) = 2p = m+1
γσ 2 . Lastly, the optimum
quantity for each eagent j ∈ J derived from (22) is q1j,∗ = m+1 n
.
nm n
After Theorem 2.5 LT1 trades in a total of m+1
units and keeps m+1
shares with the
p |n|
result that each market maker obtains a fractional compensation of m+1
= (m+1)2
γσ 2

7
 nm
after setting n to m+1
in (19). The premium p increases with the risk–aversion
parameter γ, the volatility σ and the number |n| of shares. Conversely, it decreases
when a higher count m of competitive market makers are in the market, meaning
more liquidity. In the limit m → ∞ it is p → 0 respectively S1 → µ. The same result
is obtained when considering γ, σ → 0. We can determine an upper bound for the
premium p when assuming S1 > 0 and show limitations of Grossman and Miller’s
model in [GM] and [C].
Corollary 2.6. The assertions of Corollary 2.3 and Theorem 2.5 only holds for high
liquidity markets with a low spread s = 2p resp. premium p relative to the efficient
|n|
asset price µ. The upper bound for the premium is p = m+1
γσ 2 < µ, implying an
upper bound for the number of shares |n| < (m + 1) γσµ2 .
|n|
Proof. By S1 > 0 it is p = m+1
γσ 2 < µ with (18) providing the upper bound
|n| < (m+1) γσµ2 . If LT1 wants to sell a sufficient high number of shares n ≥ (m+1) γσµ2 ,
then the liquidity premium p would exceed the efficient price µ, so that the ask price
S1 would be zero or even negative. But a negative S1 is excluded by our assumption
of nonnegative asset prices in section 1. In this case of illiquidity, S1 = 0 would inhibit
trading. Though for n = (m + 1) γσµ2 , according to the optimal quantity (16) of the
optimisation problem in Corollary 2.3, each agent is supposed to hold q1j,∗ = µ
γσ 2
mµ µ
quantities at t = 1. This implies LT1 selling γσ 2
shares while holding γσ 2
, which
contradicts to the maximisation of the utility since LT1 would make a significant
loss of wealth W1LT1 and utility U (W1LT1 ) when its shares are sold worthless. This is
the reason why the assertions of Corollary 2.3 and Theorem 2.5 only holds for high
liquidity markets with a low premium p with respect to the efficient asset price µ.

Obviously, the constraint for the premium in Corollary 2.6 does not fit into the case
when LT1 is buying at the market, because the inequalities does not provide a formal
limitation to p. However, it is from the view of utility unlikely, that LT1 would pay
double the efficient asset price rather than holding the asset. In real markets, where
the asset price could be very small, as in penny stocks or stock options markets, this
constraint can be abrogated. For example, stock options with small price notations
(could happen with a high multiplier or being far out of the money with little time
value left), say an efficient price of 0.10 of the market currency, a premium of p ≥ 0.10
resp. a bid price ≥ 0.20 may be paid by a liquidity trader, if he speculates on a
turnaround with a fair risk–reward ratio.
Example 2.7. Let us choose the parameters of the market in a way to get a higher
premium in order to give an example for the limitation of the market’s liquidity. In

8
[BCF, p. 20] appropriate coefficients of absolute risk–aversion parameter γ under
CARA utility functions are determined. Common values for γ are elements of the
interval [9.21 · 10−6 , 0.538]. If the upper bound γ = 0.538 with only m = 1 market
maker are considered, then the constraint for the premium is p = 0.269 |n| σ 2 < µ
1000 µ
implying n < 269 σ 2
≈ 3.717 σµ2 . For instance, a high volatility of σ = 1
3
and a very
9000
low efficient price of µ = 1 leads to the inequality n < 269
≈ 33.457. In this selected
extreme case, LT1 will not sell more than n = 33 units of S with M M at the time
t = 1. In reality, more than one market maker exist, the average parameters γ, σ are
lower and the efficient stock price µ is mostly higher than 1 unit of the currency. As
a comparison, for σ = 0.2, γ = 10−3 , m = 3, µ = 10 the limitation would be n < 106 .

3 Trading Costs
|n|
So far, we have ignored extra trading costs other than the spread s = 2p = 2 m+1 γσ 2
from (19) in section 2 like transaction costs for executing trades in the market. Ac-
cording to [GM, p. 628 ff.], the spread as the only trading cost does not fully capture
the notion of market liquidity, because the market maker may earn more or less than
the receiving premium p through a price change |S2 − S1 | > 0. In [GM], Grossman &
Miller do not quantitatively develop an enhancement of their market–making model
in the case with extra trading costs. Stoll explains in [S], that the spread measures
the market maker’s compensation for providing immediate liquidity by an simulta-
neous intermediation. This means that at t = 1 the market maker trades with LT1
and LT2 at the same time without a taking price risk. For example, he buys shares
from LT1 and immediately sells it to LT2 . Therefore, the spread contains only the
timing–option premium as the only component for providing immediacy. The concept
of a general transaction cost like a fee ϑ per share is supposed to cover the price risk
implied via the time lag between the two intermediate trades, i. e. the time difference
between t = 1 and t = 2, and refines the method of measuring liquidity. With the
following theorem we extend the liquidity theory of Grossman & Miller by giving a
modified liquidity premium, which includes, in addition to the pure timing–option
premium from section 2, another fee component to compensate the market makers
on their trades for their likely losses to the informed liquidity traders.

Theorem 3.1. Suppose that there exists a fee ϑ ≥ 0 per trade unit of S. Then the
optimum quantities for all agents at t = 2 are zero as in Theorem 2.1. At the time

9
t = 1 the optimal trade price is
n m
S1 = µ − γσ 2 − 2ϑ̃ (23)
m+1 m+1

with ϑ̃ := sign(n)ϑ and the liquidity premium including fees is

|n| m
p = |µ − S1 | = γσ 2 + 2ϑ . (24)
m+1 m+1
The optimum quantities for the agents j ∈ J := {LT1 , M M1 , . . . , M Mm } at t = 1 are

n m 2ϑ̃ n 1 2ϑ̃
q1LT1 ,∗ = + , q1M M,∗ = − (25)
m + 1 m + 1 γσ 2 m + 1 m + 1 γσ 2
with M M ∈ J \ {LT1 }.

Proof. The potential negativity of the modified fee ϑ̃ covers the case when LT1 is
buying (n < 0). Similar to (6) of Theorem 2.1, the optimum quantities at t = 2 are
h  i h  i
 ˜
E S3 − ϑ̃  2 − (S2 − ϑ) ˜
E S3 + ϑ̃  2 − (S2 + ϑ)

j,∗ LT2 ,∗
q2 = , q2 = (26)
γσ 2 γσ 2
for j ∈ J as they hold the same position type (long resp. short) and LT2 anticipates
their trades. For example, LT1 partly sells his initial asset position to the market
makers at t = 1, so that until t = 2 all j ∈ J hold a positive number of shares while
LT2 is endowed with a short position and after the shares of the market makers and
LT1 are sold to LT2 at t = 2, the positions are compensated. When observing the
numerators in (26), the fee terms cancel each other, so that q2j,∗ = q2LT2 ,∗ = 0 due to
E[S3 | 2 ] = S2 = µ + 2 as in the case without fees. At the time t = 1, the optimal
quantity of LT1 is
h  i
˜
E S2 − ϑ̃  S 1 = µ − (S1 − ϑ)

µ − S1
q1LT1 ,∗ = = (27)
γσ 2 γσ 2
like in (16) of Corollary 2.3 whereas for M M ∈ J \ {LT1 } one has
h  i
˜
E S2 − ϑ̃  S 1 = µ − (S1 + ϑ)

M M,∗ µ − S1 − 2ϑ̃
q1 = 2
= (28)
γσ γσ 2
as the market makers anticipates the trades of LT1 at t = 1 and LT2 at t = 2. Again,
setting (27), (28) in the demand and supply equilibrium (21), provides

µ − S1 − 2ϑ̃ µ − S1 µ − S1 2ϑ̃
n = mq1M M,∗ + q1LT1 ,∗ = m 2
+ 2
= (m + 1) 2
−m 2
γσ γσ γσ γσ

10
 n m
and finally S1 = µ − m+1
γσ 2 − 2ϑ̃ m+1 as the optimal trade price from (23). Because
n and ϑ̃ have the same sign, the liquidity premium resp. discount including the fee is
(23) |n| m
p = |µ − S1 | ==== γσ 2 + 2ϑ
m+1 m+1
as stated in (24). From (27) and (28), the optimal quantities for LT1 and the market
makers are then
(27) µ − S1 (23) n m 2ϑ̃
q1LT1 ,∗ ==== 2
==== + ,
γσ m + 1 m + 1 γσ 2
(28) µ − S1 − 2ϑ̃ (23) n 1 2ϑ̃
q1M M,∗ ==== 2
==== − .
γσ m + 1 m + 1 γσ 2
These verify the last assertion (25) of the theorem.

If ϑ = 0 is set, the situation simplifies to the one in section 2. When assuming

m


ϑ > 0, by (23) and (24), LT1 pays an additional fee m+1 2ϑ per share to the compen-
|n|
sation m+1
γσ 2 per share already determined in Theorem 2.5. In the case of a sale resp.
purchase this fee term reduces the ask price resp. raises the bid price of the traded
m
share. This means that LT1 covers a fraction m+1
of the market makers’ trading fees
2ϑ that arise from the two transactions with LT1 and LT2 , while the market makers
1


only have to bear the residual m+1 2ϑ of their accrued transaction fees. The opti-
mum quantities of holdings (25) are being fee–adjusted. For n > 0 each market maker
1 2ϑ m 2ϑ
holds less m+1 γσ 2
shares at the end of date t = 1 whereas LT1 holds m+1 γσ 2
more
of them. In the case of n < 0 the reverse adjustments are true. The fee component
m


m+1
2ϑ ∈ [ϑ, 2ϑ) of the premium is affected reciprocal by the count of market mak-
|n|
γσ 2 ∈ 0, 12 |n| γσ 2 ,

ers m ∈ N when compared to the timing–option component m+1
∂ m 1 1 ∂ |n|
since it is ∂m m+1
2ϑ = (m+1)2
2ϑ ∝ (m+1)2
|n| γσ 2 = − ∂m m+1
γσ 2 . More market mak-
ers increase the fee component while the timing–option component decreases and vice
versa.

Remark 3.2. Theorem 3.1 is stated as an exercise in [C, pp. 15–16] without a
proof, where the statement for the optimal trade price S1 in [C, p. 16] contains
m
a mistake compared to (23) as the additional fee term −2ϑ̃ m+1 is missing. The
reference considers only the case, when LT1 is selling (n > 0), so that ϑ̃ = ϑ > 0, but
the analogous conclusion holds for LT1 buying (n < 0) with a change of signs of n
and ϑ̃ as considered in (23) and (27).

Let us compute a lower barrier for the number of shares |n| with respect to the
fee ϑ, where LT1 is willing to trade with the market makers, using the results from

11
Theorem 3.1. This means, that if ϑ exceeds a upper barrier respectively |n| deceeds
a lower barrier, LT1 is not willing to trade any shares and the optimal quantity at
the end of t = 1 remains q1LT1 ,∗ = q0LT1 ,∗ = n.
2ϑ
Corollary 3.3. LT1 is not willing to trade with the market makers for |n| ≤ γσ 2
.

Proof. If LT1 does not trade at t = 1, because |n| is too small as compared to a
yet to be determined relation containing ϑ, then his optimal holding of the asset
after leaving date t = 1 is still q1LT1 ,∗ = n. Inserting (25) into the left side of the
n m 2ϑ̃ 2ϑ̃
last equation delivers m+1
+ m+1 γσ 2
= n and after reshaping n = γσ 2
. Hence, for
2ϑ
|n| ≤ γσ 2
the trader LT1 keeps his whole position n.

As a conclusion, a minimum quantity of assets is needed so that the trade for LT1
2ϑ
is economically viable. Given that the quantity lies exactly at the boundary |n| = γσ 2
,
with (23) and (24) the asset price is S1 = µ − nγσ 2 = µ − 2ϑ̃ including the liquidity
premium or discount p = |n| γσ 2 = 2ϑ. In this case, it is apparent that the premium,
as well as the asset price, does not depend on m but only on the efficient price µ and
the fee ϑ. An upper bound for the amount of shares was given by |n| < (m + 1) γσµ2
in Corollary 2.6. This bounds also holds in the case of fees, though it can be refined
through a bound less than the one without fees, as the fee term additively reduces
liquidity.

Corollary 3.4. With ϑ < 12 µ, the number of shares |n| is bounded by

2ϑ µ 2ϑ
2
< |n| < (m + 1) 2 − m 2 . (29)
γσ γσ γσ

Proof. The lower bound follows from Corollary 3.3. Apply (23) to S1 > 0 to get
|n|
m+1
γσ 2 m
+ 2ϑ m+1 < µ and after algebraic rearrangement |n| < (m + 1) γσµ2 − m γσ
2ϑ
2 as

an upper bound. Since the upper bound must be greater than the lower bound it is
2ϑ
γσ 2
< (m + 1) γσµ2 − m γσ
2ϑ 2ϑ µ
2 , which is equivalent to (m + 1) γσ 2 < (m + 1) γσ 2 and thus

ϑ < 12 µ.

The upper bound for the number of shares in (29) can be further lowered when
taking into account the fee of the liquidity trader’s transaction at t = 1.

Corollary 3.5. The effective price S1eff after transaction fees for LT1 is
n 3m + 1
S1eff = µ − γσ 2 − ϑ̃ (30)
m+1 m+1

12
with the effective liquidity premium (or discount)

|n| 3m + 1
peff = γσ 2 + ϑ. (31)
m+1 m+1
Under the constraint ϑ < 13 µ, the boundaries for the number of shares |n| are

2ϑ µ ϑ
2
< |n| < (m + 1) 2 − (3m + 1) 2 . (32)
γσ γσ γσ
Proof. Not only that LT1 pays a significant fraction of the market makers’ fees through
a wider spread, but he also has to pay is own transaction cost ϑ. The effective
(23) n 3m+1
transaction price per share is then S1eff = S1 − ϑ̃ ==== µ − m+1
γσ 2 − m+1
ϑ̃ and
elucidates (31). The consideration of an positive effective price S1eff > 0, to enable a
sell of LT1 , provides with (30) the condition |n| < (m + 1) γσµ2 − (3m + 1) γσϑ 2 . The
lower bound is clear according to Corollary 3.3, so that the limitations of |n| in (32)
are proven. The validation of the constraint ϑ < 31 µ follows analogous to Corollary
3.4 by solving 2ϑ
γσ 2
< (m + 1) γσµ2 − (3m + 1) γσϑ 2 with respect to ϑ.
3m+1
The fee component m+1
ϑ of the effective premium (31) lies in the interval [2ϑ, 3ϑ),
as compared to the one in (24). This is consistent with the discussion before, that
for a large number of market makers LT1 pays almost three times the fee, in fact for
his own transaction plus the two transactions of the market makers.

Example 3.6. Choosing the market parameters (γ, σ, m, µ) = (0.538, 13 , 1, 1, 0.2) with
ϑ = 0.2 respectively (γ, σ, m, µ) = (10−3 , 0.2, 3, 10) with ϑ = 2 from Example 2.7
provide |n| ∈ (6.692, 20.074) (in contrast to |n| ∈ (0, 33.457) in the case ϑ = 0) resp.
|n| ∈ (105 , 5 · 105 ) (compared to |n| ∈ (0, 106 ) for ϑ = 0).

In summary, we have modelled trading costs of a market player as a fixed fee per
share per transaction making the entire fees sum up to |n| ϑ, which can be large when
the amount of shares traded is large, too. In real markets it is unusual to pay fees in
this way but rather dependent on the trade volume plus a fixed charge per transaction.
By way of example, according to the Trading Services Price List of the London Stock
Exchange [LSE, pp. 2–3], the exchange charges 0.45bp = 0.0045% (bp = basis points)
of the order volume plus a fixed order management charge (1p per non–persistent
order entry and possibly a high usage surcharge of 5p per event) for trading equities.
Basically, the order volume of the trade at t = 1 is the product n − q1LT1  S1∗ of the
 

quoted bid or ask price S1∗ before fees and the number of shares traded, implicitly
given by the absolute difference between the initial endowment q0LT1 = n at t = 0 and

13
the quantity of holdings q1LT1 at t = 1 of LT1 . Because the optimum quantity q1LT1 ,∗
is a priori unknown but after solving the optimisation problem, we replace it by the
amount of shares |n| from the long or short position, that LT1 brings into the market
at t = 1. Moreover, a substitution of S1∗ with the known efficient price µ leads to an
approximation of the trade volume through |n| µ, only containing known parameters
in our model, to develop a similar optimisation problem to the one of Theorem 3.1.
Certainly, |n| > n − q1LT1  causes a higher trade volume and hence higher expected
 

transaction costs, but for a large count m of market makers and a relatively low fees
the optimum quantity q1LT1 ,∗ should be small enough to neglect the difference. The
same goes for µ, since S1∗ only contains the timing–option component without the fee
component.

Corollary 3.7. Let ϑ := ϑ0 + |n| µϑ1 be the fee per transaction with a fixed charge
ϑ0 ≥ 0 and a small volume–dependent charge rate ϑ1 ∈ [0, 1). With ϑ̃0 := sign(n) we
write again ϑ̃ := sign(n)ϑ = ϑ̃0 + nµϑ1 to cover both cases sign(n) = ±1. At the date
t = 2 the optimum quantities for all agents are zero like in Theorem 2.1. At t = 1
the optimal trade price a market maker offers to LT1 is
 
n 2 ϑ0 m
S1 = µ − γσ − 2 + µϑ̃1
m+1 n m+1

with ϑ̃1 := sign(n)ϑ1 and the liquidity premium including fees is

!
|n| ϑ̃0 m
p = |µ − S1 | = γσ 2 + 2 + µϑ1 .
m+1 n m+1

The optimum quantities for the agents j ∈ J := {LT1 , M M1 , . . . , M Mm } at t = 1 are

n m 2(ϑ0 + nµϑ̃1 ) n 1 2(ϑ0 + nµϑ̃1 )

q1LT1 ,∗ = + , q1M M,∗ = −
m+1 m+1 nγσ 2 m+1 m+1 nγσ 2
with M M ∈ J \ {LT1 }.

Proof. We transform the case to the one of Theorem 2.5, where the optimisation
problem of charging only a fixed fee per share and transaction was solved. Since nS1
ϑ ϑ0
is the position volume of LT1 at the beginning of t = 1, the quotient n
= n
+ µϑ̃1 is
being interpreted as the fee premium or discount per share and transaction. All its
parameters ϑ0 , ϑ̃1 , n, µ are known at t = 1, so that it can be used as a replacement
for ϑ̃ in Theorem 2.5 to get the results stated.

Corollary 3.7 presents an idea how to extend Grossman & Miller’s model with
volume–based trading costs, but has a flaw when using µ in the approximation |n| µ

14
of the trade volume due to the errors implied by significant differences |S1 − µ| or
|S2 − µ| and the fact that at t = 2 the price can change with a clear difference S2 − S1
affecting the trade volume with LT2 . The next approach tries to fix this weak point
by writing |n| St for the trade volumes in t ∈ {1, 2}.
Theorem 3.8. Let ϑ̃ = ϑ̃0 + nSt ϑ1 be the fee premium resp. discount per transaction
with a fixed charge ϑ0 ≥ 0 and a volume–dependent charge rate ϑ1 ∈ [0, 1). Then the
optimum quantities at t = 2 of all agents are zero. The asset price at t = 1 is
nγσ 2 2mϑ0
S1 = µ − − (33)
(m + 1)(1 − ϑ̃1 ) n(m + 1)(1 − ϑ̃1 )
with liquidity premium including fees
|n| γσ 2 2mϑ0
p = |µ − S1 | = + . (34)
(m + 1)(1 − ϑ̃1 ) |n| (m + 1)(1 − ϑ̃1 )
The optimum quantities for the agents at t = 1 are
n 2mϑ0 n 2ϑ0
q1LT1 ,∗ = + 2
, q1M M,∗ = − . (35)
m + 1 (m + 1)nγσ m + 1 (m + 1)nγσ 2
 
Proof. The asset price after fees is nS1n−ϑ̃ = St − ϑn0 + St ϑ̃1 = (1 − ϑ̃1 )St − ϑn0 Then
the optimum quantity at t = 2 is
h  i  
ϑ0 ϑ0
E (1 − ϑ̃1 )S3 ±  2 − (1 − ϑ̃1 )S3 ±

n n
q2j,∗ = ,
γσ 2
where ± = − for j ∈ J and ± = + for j = LT2 . Like in (26) the terms in the
numerator cancel each other implying q2j,∗ = 0 for all agents j ∈ J ∪ {LT2 }. At t = 1
the optimum quantities are
h  i  
E (1 − ϑ̃1 )S2 − ϑn0 S = µ − (1 − ϑ̃1 )S1 − ϑ0

 1 n µ − S1
q1LT1 ,∗ = = (1 − ϑ̃1 ) ,
γσ 2 γσ 2
h  i  
E (1 − ϑ̃1 )S2 − ϑn0  S 1 = µ − (1 − ϑ̃1 )S1 + ϑ0

M M,∗ (1 − ϑ̃1 )(µ − S1 ) − 2ϑn0
n
q1 = =
γσ 2 γσ 2
different from (27) and (28). The demand and supply equilibrium (21) provides (33)
and (34) and with them (35).

4 Acknowledgments
I would like to thank Professor Álvaro Cartea for making me enthusiastic about the
theory of market making during his high–frequency trading lectures at Oxford. I
hereby confirm that I have written the present thesis independently and without
illicit assistance from others than the indicated sources.

15
References
[C] Álvaro Cartea. Market Microstucture, Notes based on textbook ’Algorithmic
and High-Frequency Trading’. University of Oxford, 04.03.2016.

[GM] Sanford J. Grossman, Merton H. Miller. Liquidity and Market Struc-

ture. The Journal of Finance 43(3) (1988), pp. 617–637.

[BCF] Bruce A. Babcock, E. Kwan Choi, Eli Feinerman. Risk and Proba-
bility Premiums for CARA Utility Functions. The Journal of Agricultural and
Resource Economics 18(1) (1993), pp. 17–24.

[S] Hans S. Stoll. Alternative Views of Market Making. In Y. Amihud, R. Ho and

R. Schwartz (eds.), Market Making and the Changing Structure of the Securities
Industry. Lexington Books (1985), pp. 67–92.

[LSE] London Stock Exchange Limited. Trading Services Price List

(On–Exchange and OTC). http://www.lseg.com/sites/default/files/content/
documents/Trading%20Services%20Price%20List%202017%20effective%2013
Mar2017.pdf, 13th March 2017.

16